The “choice of entity” discussion is unavoidable for start-up companies. In the spirit of the lifecycle of a business, it is one of the more prudent and pertinent discussions to have with your tax adviser. While sometimes an afterthought, this is a crucial matter and a misstep can prove costly.
Tax accountants love to dabble in the discussion and one can find a multitude of articles that provide a business case for any type of entity. Financial, asset protection, taxation and investor considerations play a big part. Also, the service or product of the business and exit strategy has some bearing.
There are essentially six common entity choices for a new venture: sole proprietorship, general partnership, limited partnership, limited liability company, S corporation or regular “C” corporation. All have their own nuances and pros/cons. In the end, it is a business decision based on known facts and circumstances.
It is worth noting the majority of businesses in the United States are organized for tax purposes as sole proprietorships. In 2009, there were more than 22.6 million nonfarm sole proprietorships out of 33.6 million total business returns. There were 1.7 million C corporations, 1.9 million farms, 3.1 million partnerships, and 4.1 million S corporations. The number of passthrough entities surpassed the number of C corporations in 1987 and has nearly tripled since then, led by growth in small S corporations (those with less than $100,000 in assets) and LLCs taxed as partnerships.
A sole proprietorship is a simple form of business and one can operate in the form of a single-member LLC. It is a very easy form of start-up, less expensive and there is no double taxation. However, there is very limited utility/flexibility for entrepreneurs and lack of structure for equity issuances.
The partnership form of entity, general or limited, offers passthrough of taxable income, loss and credits to its partners and is therefore not subject to double taxation. This may offer less flexibility for raising additional capital. The origin of formation may also be project based, which makes it more perfect for short-term projects and real estate build-outs.
The subchapter S corporation provides passthrough benefits as well as the corporate form of ownership. One of the more notable disadvantages is limitations on type of shareholders and capital structure (a S corporation can only have one class of stock). Thus, if additional equity needs arise there is more planning and complexities potentially involved.
The LLC form of entity has gained popularity and can best be described as a hybrid between a C corporation and a general partnership. It offers the passthrough tax benefits and is an effective shield against personal liability. As with the other choices, the LLC does not offer the best option for additional capital funding.
An important note on any passthrough option is in regards to multi-state operations. If the business operates in multiple state tax jurisdictions, the business owners may be subject to state income tax filing in addition to entity level filings.
As is often the case, the serial entrepreneur will eventually be seeking to grow and expand the business, which may require additional capital via equity or debt financing from private equity firms and venture capital funds. Such groups prefer to invest in entities that have a flexible capital structure, which may lend itself to a wider variety of financial instruments such as preferred stock, warrants, subordinated debt and convertible notes. Also, such a business may be in the position of attracting and retaining employees through the use of stock-based compensation.
With that said, the entity described above is none other than the regular C corporation and is probably the least thought about entity for start-up companies. The element of double taxation is the biggest disadvantage in addition to the costly corporate governance aspects. But it is not a deal killer by any means.
In the end, the choice of entity discussion is always productive. I strongly suggest vetting all entity types with a tax professional before making a decision.
J. Eustis Corrigan Jr. is a partner and firmwide director of tax services for HORNE LLP.